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Global
5 December 2008
World Outlook
Searching for a new source of
global demand growth
Deutsche Bank Securities Inc.
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APPENDIX 1
Economics
Editors
Peter Hooper
(+1) 212 250-7352peter.hooper@db.com
Thomas Mayer
(+44) 20 754-72884tom.mayer@db.com
Production editors
Mark Wall
(+44) 20 754-52087
mark.wall@db.com
Torsten Slok
(+1) 212 250-2155
torsten.slok@db.com
Contributors
Stefan Bielmeier
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stefan.bielmeier@db.com
Michael Biggs
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michael.biggs@db.com
George Buckley
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george.buckley@db.com
Gustavo Canonero
(1) 212 250-7530gustavo.canonero@db.com
Binky Chadha
(1) 212 250 4776
bankim.chadha@db.com
John Clinkard
(416) 682-8221
john.clinkard@db.com
Gillian Edgeworth
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Peter Garber
(+1) 212 250-5466
peter.garber@db.com
Darren Gibbs
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Caroline Grady
(+44) 20 754-59913caroline.grady@db.com
Arend Kapteyn
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arend.kapteyn@db.com
Michael Lewis
(+44) 20 754-52166michael.lewis@db.com
Yaroslav Lissovolik
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yaroslav.lissovolik@db.com
Mikihiro Matsuoka
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Tony Meer
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adam.boyton@db.com
Bernd Meyer
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David Naude
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david.naude@db.com
Joseph LaVorgna
(+1) 212 250-7329
joseph.lavorgna@db.com
Carl Riccadonna
(+1) 212 250-0186
carl.riccadonna@db.com
Torsten Slok
(+1) 212 250-2155
torsten.slok@db.com
Michael Spencer
(+852 ) 2203-8303
michael.spencer@db.com
Mark Wall
(+44) 20 754-52087
mark.wall@db.com
Macro
GlobalMarketsResea
rch
Economics
In mid-October we cut our forecasts to well below consensus. With financialconditions continuing to deteriorate and exact even more pain on households
and firms than expected, we see good reason to mark our views down still
further. We now expect global growth to be barely above zero in 2009 (about
1% lower than in our previous projection), with downturns in all major regions
setting records not seen in the past 50 years.
This deep recession marks the end of a long-term expansion that wascharacterised by a few key industrial countries assuming the role of the global
net consumer, and all other countries the role of the net producer.
Consumer demand in major industrial countries should be depressed forsome time to come by tremendous losses in household wealth and a severe
credit crunch. Massive fiscal stimulus, especially in the US should fill a good
deal of this gap in aggregate demand: enough to avert serious risk of
deflation, but not enough to ensure a self-sustaining expansion of global
growth for some time to come in our view.
In our view, a new engine of private demand growth will be needed, and wesee a likely candidate in the still largely untapped consumption potential of the
rapidly expanding middle classes in the large emerging market countries.
World Economy in Deep Recession
GDP growth, % CPI inflation, %
2007 2008F 2009F 2010F 2007 2008F 2009F 2010F
G7 2.2 0.9 -2.0 1.3 2.2 3.3 0.2 1.1
--US 2.0 1.2 -2.0 1.6 2.9 4.0 -0.4 1.5
--Japan 2.1 0.3 -1.7 0.7 0.0 1.5 0.0 -0.5
--Euroland 2.6 0.9 -2.5 1.0 2.1 3.3 1.2 1.4
EM Asia 9.4 7.1 4.6 5.7 4.4 7.2 3.0 2.6
--China 11.9 9.1 7.0 6.6 4.8 6.0 0.6 1.0
EMEA 6.8 5.2 1.1 3.5 10.5 13.0 7.7 6.0
Latam 5.5 4.3 1.8 3.0 7.0 9.2 7.4 5.9
Industrial
countries 2.4 0.9 -2.0 1.2 2.2 3.4 0.5 1.2EM
countries 8.1 6.1 3.3 4.7 5.7 8.2 4.1 3.6
Global 4.7 3.1 0.2 2.6 3.6 5.3 1.9 2.2
Source: DB Global Markets Research
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Global Overview: Searching for a new driver of global demand growth
In mid-October we cut our forecasts to well belowconsensus. With financial conditions continuing
to deteriorate and exact even more pain on
households and firms than expected, we see good
reason to mark our forecasts down still further.
We now expect global growth to be barely above
zero in 2009 (about 1% lower than in our previous
projection), with downturns in all major regions
setting records not seen in the past 50 years.
This deep recession marks the end of a long-termexpansion that was characterised by a few key
industrial countries assuming the role of the
global net consumer, and all other countries the
role of the net producer.
Consumer demand in major industrial countriesshould be depressed for some time to come by
tremendous losses in household wealth and asevere credit crunch. Massive fiscal stimulus,
especially in the US should fill a good deal of this
gap in aggregate demand: enough to avert
serious risk of deflation, but not enough to ensure
a self-sustaining expansion of global growth.
In our view, a new engine of private demandgrowth will be needed, and we see a likely
candidate in the still largely untapped
consumption potential of the rapidly expanding
middle classes in the large emerging market
countries.
Even so, this restructuring of the global economyshould take some time, and the initial expansionto come after the sharp downturn now under way
looks likely to be unusually sluggish overall, with
fits and starts of growth driven primarily by policy
stimulus over the next couple years.
The growth of public debt in the fight againstrecession should push public sector debt burdens
significantly higher in many industrial countries.
With the fiscal costs associated with retiring baby
boomers drawing nearer, this increases the risk
that monetisation of the excessive government
debt will eventually fuel inflation.
The gloom thickensAs we began our Q4 review of the world outlook, it
became clear that the intensification of the global credit
crunch and asset price deflation meant that our relatively
pessimistic view of global economic prospects would
need to be adjusted down further. Our forecast of a
serious global recession as of mid-October has now been
revised to a deep and unprecedented (at least since the
Great Depression) downturn (cover table). Growth in most
major regions of the world for 2009 has been marked
down by about 1% point. Notable exceptions are EMEA,
where the markdown was substantially more than 1
percentage point and Japan and Latin America, where it
was somewhat less. We project global growth at just
above zero in 2009, nearly two percentage points below
the mild recession level of 2%.
The global GDP revisions were driven in part by a weaker
outlook for the US (decoupling is clearly dead in our view)
and in part by weaker domestic fundamentals in each
region. We now see record rates of decline in consumer
spending lasting even longer than previously, business
spending on plant and equipment falling more sharply,
and inventory runoff continuing at a rapid pace through
the first half of 2009. The deeper downturn does not
beget a stronger recoveryour outlook for a sluggish
pickup in 2010 has not changed appreciably. Nor have our
projections of aggressive fiscal policy action changed; it
now seem more likely to be realized, at least in the US.
However, we see inflation falling further and central bankpolicy rates remaining lower for longer. Indeed, we have
marked down global inflation by a full percentage point in
2009 as well, thanks in part to the lower trajectory of oil
prices that the growth forecast yields. We now see oil
prices as remaining in the neighborhood of $50 per barrel
through 2009 and rising in 2010 (see section on
commodities below). We project headline inflation to turn
slightly and temporarily negative in the US next year, but
to rise again as commodity prices stabilize at a low level.
We do not see deflation as a serious risk thanks to
aggressive monetary and fiscal policy actions being taken.
A watershed eventSome recessions are mere hick-ups in a basically intact
longer-term expansion. Others are watershed events. In
our view, the present recession now falls even more
dramatically into the second category. It marks the end of
a long-term expansion that was characterized by a few
key industrial countries assuming the role of the global net
consumer, and all other countries the role of the net
producer. This international division of labour was made
possible by trade and financial globalisation, and the
availability of cheap credit. Trade integration allowed the
shipping of goods and increasingly services through the
internet around the world, while financial integration
allowed the funding of ever larger trade imbalances. With
inflation running fairly low, central banks kept monetary
policy relatively accommodative while financial
engineering was ever reducing apparent credit risk. In this
world, the national accounting equality of savings and
investments became irrelevant at the national level. No
imbalance seemed to be too big not to be funded by the
international capital markets. However, as countless
merchants supplying customers on credit have found out
since the advent of commerce, business turns sour when
the customers cant repay their debts. The US sub-prime
crisis of 2007 was the signal that this endpoint was finally
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being reached in the credit-driven consumption boom that
had begun twenty five years earlier.
Chart 1. An era of US domestic demand driven growth
8000
8500
9000
9500
10000
10500
11000
11500
12000
12500
1997 1999 2001 2003 2005 2007
$ bln
8000
8500
9000
9500
10000
10500
11000
11500
12000
12500
$ blnUS: real domestic demand
US: real GDP
Source: BEA, DB Global Markets Research
Chart 2. Decline of US household savings rate coming toan end
-2
0
2
4
6
8
10
12
14
1980 1984 1988 1992 1996 2000 2004 2008
%
-2
0
2
4
6
8
10
12
14
%
US savings rate
Source: BEA, DB Global Markets Research
Averting deflation
We have learned from the experience of the 1930s that
mass destruction of debt through bankruptcy will cause
deflation and depression when resolution is left to the
private sector alone. As banks and companies fall like
dominos, unemployment surges andin the absence of a
social security netincomes and demand plunge. Sayslaw is at work, albeit with a negative sign: falling supply
induces falling demand. As producers compete in cutting
prices and consumers wait for prices to fall further,
deflation kicks in. To prevent such a vicious cycle, the
public sector has to take over bad debt from the private
sector, support the incomes of the unemployed, and add
direct stimulus to aggregate demand. We have also
learned from the Japanese experience that to be
successful, the public sector has to act quickly and
forcefully.
Chart 3. The US Depression
0
20
40
60
80
100
120
1929 1930 1931 1932 1933 1934 1935
Index
0
20
40
60
80
100
120
Index
Output/man hour
Capital Outlay (Nominal)
S&P index
Industrialproduction
GNP (Real
CPI
Source: Historical Statistics of the US, DB Global Markets Research
Policy action
The good news is that US economic policy seems to
broadly meet these requirements. Banks have beenrecapitalised and the Fed is funding potentially impaired
assets. Monetary policy has been eased very aggressively
and a big fiscal policy impulse can be expected for 2009
after a more moderate programme earlier this year. The
bad news is that European economic policy has not risen
to the occasion. Bank recapitalisation programmes have
been launched, but the take-up has been slower than in
the US (in part because tough conditions have been
attached to these programmes and in part because
national implementation has led to conflicts with
European competitiveness policy). Monetary policy was
inactive or moved in the wrong direction for more than a
year until the threat of a global financial meltdown forced
European central banks into a policy U-turn in October
(Table 1). More powerful fiscal policy action is undermined
by a dithering German government. Hence, we continue
to expect that the recession will be more severe in Europe
than in the US (Table 2). Still, thanks to some spill-over
effects from the US, some home-made policy support, a
lesser sensitivity to oil price declines and a greater degree
of wage stickiness, deflation is a relatively low probability
in Europe as well. Indeed, for these reasons, we see
inflation in Europe remaining noticeably positive next year
despite a dip in to negative territory in the US.
1. European rates catching up
Central bank rate, % 10Y yields, %
Cur-
rent 3M 6M 12M
Cur-
rent 3M 6M 12M
US 1.00 0.50
0.50 0.50 2.72 2.00 2.00 2.50
Japan 0.30 0.10
0.10 0.10 1.39 1.50 1.50 1.30
Euroland 2.50 2.00
0.75 0.75 3.05 2.50 2.25 2.00Source: DB Global Markets Research, as December 5
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2. Deep recession and shallow recovery
GDP growth, % CPI inflation, %
2007 2008F 2009F 2010F 2007 2008F 2009F 2010F
G7 2.2 0.9 -2.0 1.3 2.2 3.3 0.2 1.1
--US 2.0 1.2 -2.0 1.6 2.9 4.0 -0.4 1.5
--Japan 2.1 0.3 -1.7 0.7 0.0 1.5 0.0 -0.5
--Euroland 2.6 0.9 -2.5 1.0 2.1 3.3 1.2 1.4
EM Asia 9.4 7.1 4.6 5.7 4.4 7.2 3.0 2.6
--China 11.9 9.1 7.0 6.6 4.8 6.0 0.6 1.0
--India 9.3 7.2 4.8 6.8 4.6 9.6 5.3 4.3
EMEA 6.8 5.2 1.1 3.5 10.5 13.0 7.7 6.0
--Russia 8.1 6.9 1.0 4.0 11.9 13.8 8.2 7.4
Latam 5.5 4.3 1.8 3.0 7.0 9.2 7.4 5.9
--Brazil 5.4 5.2 2.7 3.5 4.5 6.3 5.5 4.5
Industrial
countries 2.4 0.9 -2.0 1.2 2.2 3.4 0.5 1.2EM countries 8.1 6.1 3.3 4.7 5.7 8.2 4.1 3.6
Global 4.7 3.1 0.2 2.6 3.6 5.3 1.9 2.2Source: DB Global Markets Research
Growth stabilizers
In addition to policy actions, private demand downturns
have some self-limiting features that help to bring
recessions to an end. Cyclical swings in demand are
dominated by shifts in purchases of durable goods (most
importantly autos), houses, and business plant and
equipment. In the US, these components of demand
account for roughly one-third of total GDP. In a deep
recession, they fall sharply and as they reach a bottom,growth stabilizes. The good news for the US economy
this time around is that home building has fallen sharply
over the past 2-1/2 years and has already reached a record
lowit does not have room to fall much further, and is
now running at levels that are well below the
demographic growth in demand, meaning it will not be
too long before this sector begins to make a positive
contribution to growth. Likewise, while indicators of
business spending are now plunging, that spending was
relatively low to begin with going into this downturn, and
it too is unlikely to be an important drag on growth past
mid-2009. The major uncertainty is how far spending on
consumer durables and even nondurables will fall. Prior to
the current downturn, real consumer spending had never
declined more than two quarters in a row, at least since
the inception of the US National Income and Product
Accounts in 1947. This time around, we see consumer
spending declining 4 quarters in a row, through mid-2009.
More importantly, that spending will face significant
headwinds after it has bottomed as households strive to
cut debt levels and rebuild very low saving rates.
A new source of global demand growth
Although help from fiscal policy and natural spending
stabilizers is essential to averting deflation and limiting the
extent of the recession, a new self-sustaining expansion
cannot be based on fiscal expansion alone. Nor can we
depend on the US consumer to lead the charge this time
around. Efforts to translate the high national savings in
Japan and Germany into stronger consumption in these
countries have not succeeded in the past, although theremay be some hope if rapidly ageing populations begin to
consume more of their financial assets in retirement. Even
so, the industrial economies may well be too stretched
financially and in some cases too reluctant to take needed
policy actions to contribute their traditional share to global
economic expansion ahead. Fortunately, a new and
potentially powerful source of global demand may be
waiting in the wings: the so far still largely untapped
consumption potential of the growing middle classes in
the big emerging market countries. The needs and tastes
of Chinese, Indian and Brazilian middle class families may
have to take over from the US consumer and its
associates in spearheading the stimulation of global
production in the future. And those who until recently
have benefited from cheap goods produced in these
countries will in the future turn into their suppliers.
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Chart 4. Untapped consumption potential in emerging
market countries
70.3
56.3 57.3
35.4
55.5
60.9
48.5
0
10
20
30
40
50
60
70
80
US Euro Area EuropeanUnion
China India Brazil Russia
%
0
10
20
30
40
50
60
70
80
%Personal consumption expenditure as % of GDP
Source: DB Global Markets Research
A reduced global saving glut means that growth in
individual countries will in the future probably be more
constrained by their ability to fund investments through
their own savings rather than from abroad. With less
capital having to be shipped around the world to fund
national saving-investment imbalances the global financial
sector can be smaller than it was in the past. Hence, while
trade globalisation (and the benefits from international
trade integration) is likely to stay, financial globalisation
will probably retreat as more investment will be financed
by savings at home.
Bridging the gap
The restructuring of the global economy will of course
take time, and until it is completed global growth may well
seesaw, with recessions trading places with short-term
rebounds on the back of fiscal policy stimuli. Modest
recovery in the second half of next year, as presently
envisaged by many forecasters, ourselves included, could
well be followed a renewed weakening several quarters
later. And the Bush fiscal stimulus programme of 2008
may be followed by more than one Obama stimulus
programme in 2009 and later years. Our forecast sees a
period of some volatility in growth that overall is fairly
sluggish by historical standards, with relatively slow
progress made in bringing down high rates of
unemployment until the new driver of the next globalexpansion is finally in place.
Chart 5. Fiscal policy aiming to revive growth
-3.5
-3.0
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
1999 2001 2003 2005 2007 2009
% of GDP
-3.5
-3.0
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
% of GDP
US
Euroland
Fiscal impulse (= change incyclically adjusted budgetbalance)
Easing
TighteningForecast
Source: OECD, DB Global Markets Research
Fiscal burden and ultimately inflation risk
Taking over bad debt from the private sector now and
incurring new debt in the fight against recession is likely
to leave the public sector with a very high debt burden in
most industrial countries. In fact, expected future tax
revenues may not be enough to cover debt service and all
other government expenses, especially when public
pension liabilities are taken into account. Fortunately,
governments suffering from an excessive debt burden
extremely rarely default. As economic history through the
centuries has shown, they usually manage to obtain
missing funds from their central banks. It is unlikely to be
different this time. An oversupply of liquidity caused by
central bank funding of government debt should lower
exchange rates against the currencies of the faster
growing emerging market economies and encourage
wage and price increases. Thus, the monetisation ofthe excessive government debt should eventually fuel
inflation. Higher inflation should erode the claims of
nominal debt holders to real values that are eventually
consistent with the debt service capacity of the
governments. But the eventual rise in inflation is likely to
be still several years off.
Conclusion
As we enter the third year of the financial crisis the
outlook has worsened further. We are likely to avoid
deflation, but a deep and potentially long recession
(through at least the middle of 2009) seems inevitable.
Thereafter, the over-indebted consumers in the industrialworld will probably have to settle for lower growth and
higher inflation than they experienced in the last two
decades. Following a possibly extended period of sluggish
global recovery, a key driver of the next self-sustaining
global expansion is likely to be increased consumer
spending by the growing middle classes in the major
emerging market countries.
Peter Hooper, (1) 212 250-7352
Thomas Mayer, (44) 20 754-72884
Torsten Slok, (1) 212 250-2155
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Geopolitics: Recession = Oil Deflation = Geopolitical Power Deflation
The financial crisis and the resulting economic crisis have
shifted attention almost entirely from geopolitical issues
toward restoring economic growth. As a result, the
urgency of resolving in the near term outstanding issuessuch as the Iran nuclear dispute has been reduced. While
the economic slowdown has not yet brought into
question the size of US military expenditure, the need to
finance the huge stimulus package just placed on the
table by the incoming Obama Administration will
ultimately lead there. In the 2008 fiscal year, military
expenditures were about $600 billion or 4 percent of GDP.
In any case, the winding down of the deployment to Iraq
will naturally reduce US expenditures. The promised surge
of forces to Afghanistan will likely amount to no more than
two additional brigades due to logistical constraints.
As a further geopolitical side effect, the sharp economiccrisis has collapsed the price of oil by two-thirds from
peak, with some prospect for a further decline. This has
cut the financial knees from under several countries that
have adopted in recent years a more forward geopolitical
program: Iran, Venezuela, and Russia. Nevertheless, the
reserves built up during the oil boom will allow these
programs to continue in the near term if from inertia
alone.
Iran
In the presumed chronology of events surrounding efforts
to derail Irans nuclear development program, the next
couple of months have always been emphasized as adangerous moment. In this chronology, the period
between the US presidential election on November 3 and
the inauguration of a dovish Democratic Party victor on
January 20 would either force a military effort by the
outgoing Bush administration or a strike by the Israeli air
force against the nuclear facilities. The former was
precluded at the end of 2007 by the release of the
remarkably benign National Intelligence Estimate on Irans
nuclear program. The document claimed that Iran had
abandoned its nuclear weapons program in 2003. A
conflict between the US and Iran right now would add the
further catastrophe of a closure of oil flows from the
Persian Gulf to the existing economic crisis and potentially
drive the world economy to the breaking point. So that
makes US action doubly unlikely. The Bush
administrations parting shots have taken the form of
missile attacks from drones aimed at al Qaida leadership
along the Pakistan-Afghanistan border.
However, the latest IAEA report of November 19 stated
that Iran has installed 3800 working centrifuges to enrich
uranium and will install an additional 3000 next year. Iran
now has 630 kg of low enriched uranium and needs 800
kg to have enough to further enrich into a weapon. This
level can be reached by early next year. However, it is
most likely that Iran will simply continue with its low
enrichment program to establish a stockpile large enough
for a much greater number of weapons before taking thenext step.
That leaves Israel. There have been numerous threats of
an Israeli strike from official sources in Israel. But Israel
lacks sufficient force to have much impact without US
acquiescence. For reasons stated above, the US appears
to be warning Israel off.
Iran is very vulnerable to the decline in oil price, with
eighty percent of it foreign exchange revenues derived
from oil. Both its internal social and external geopolitical
subsidy programs will have to be cut back soon enough,
But the investment in enrichment has already been made,so it will move to completion on its own momentum.
The most likely outcome now is an eventual global
acquiescence in a nuclear armed Iran.
Russia
Russia has been smarting from the expansion of NATO
into its sphere, the basing of US anti-missile installations
in Poland and the Czech Republic, and US responses to
the conflict in Georgia. Furthermore, the rapid growth of
the Russian economy in recent years and its importance in
the energy market have rekindled a desire to establish a
geopolitical weight commensurate with being a greatpower. As a result it has embarked on a program to
rationalize and rearm its military, and effort to gain
recognition of its pre-eminence in the near abroad states
of the former Soviet Union, and an effort to jostle the US
in its backyard by renewing its support for Cuba and
Venezuela. These initiatives are costly, except for the
Caribbean activities, which are on a commercial basis so
far. The collapses of the oil price and the global financial
crisis have hit the Russian financial system hard. The
decline in revenues from oil will inevitably force a
retrenchment of these strategic plans. However, Russia
has been relatively frugal during the oil boom,
accumulating above $500 billion in foreign exchange
reserves. Although interventions to stem the capital flight
after the Georgia war and the effects of the financial crisis
have brought reserves to $475 billion, this can still support
the implementation of military modernization in the short
term.
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Venezuela
This time around Russia is leaving the costs of subsidizing
an anti-US coalition in the Caribbean to Venezuela, making
minimal shows of military force in the form of a couple of
strategic bombers and a demonstration by a small naval
squadron. It is selling arms to Venezuela on a scale that is
relatively large for the region, but on a commercial basis.
Venezuela and Iran are similar in their large budgetary
commitments for armament programs, for subsidizing
allies, and for subsidizing social programs, all based on oil
revenues. With half of government revenues and 90
percent of exports coming from oil, Venezuela is just as
vulnerable to the sudden collapse in oil prices. With
reserves of $38 billion, there is about a year before it will
have to scale back its various programs, including the
geopolitical one, unless the time is advanced by a larger
capital flight.
A little bit on all those aircraft carriers
In its rearmament program, the government hassuggested that Russia may build up to six aircraft carriers.
This followed close on a suggestion from China that it
would build one aircraft carrier. (The UK and France are
committed to building a total of three large aircraft carriers
between them.) These plans seem strange given the ever
increasing vulnerability of these huge military assets.
Aircraft carriers are for the projection of offensive power
over long distances where basing of aircraft may be
problematic. This makes no sense for coastal defense. To
build a serious aircraft carrier costs well above $5 billion.
But then you need to build half a dozen escort vessels and
the aircraft to produce a battle unit that will requireupwards 10,000 sailors. Since it is for distant power
projection, to keep a single aircraft carrier group on
constant deployment requires at least two and more likely
three groups. This is an enormously costly strategic
decision. Since its development has been in the industrial
sector, China has the resources to build an aircraft carrier,
and a single one would provide an experimental unit to
serve as a learning platform. But even with vaster
resources than Russia now has, the Soviet Union could
not perfect an aircraft carrier. With the rapidly waning
financial clout, Russia is unlikely to implement this
program very soon.
Peter Garber, (1) 212 250-5466
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US Equity Strategy
Equity markets are pricing the worst post-war
recession. The current sell-off in the S&P 500 (-51.9%),
measured peak-to-trough, exceeds all post-war sell offs. It
is now bigger than the post-tech-bubble sell off and theworst recession-related sell off in 1973-75. Like the post-
tech-bubble selloff in 2000-02, much of the 1973-75 sell-
off also represented a derating. That recession saw a
peak-to-trough decline in trailing four quarter earnings of
15%, while equities fell by 48%, indicating a significant
derating, in our view reflecting the oil supply shock that
rendered portions of the existing capital stock obsolete.
Equities are thus pricing in a deep and long recession,
worse than any in the post war period (Figure 1).
Figure 1: The worst post-war equity sell-off
-90
-80
-70
-60
-50
-40
-30
-20
-10
0
% decline for S&P 500 from peak to trough around
recessions
Source: S&P, NBER, Haver, Deutsche Bank
Historically, equities have bottomed a little more than
half way through recessions, recovering significantly
before it ends. There are several empirical regularities in
the behavior of equity markets around past recessions. (i)
On average, they lost 32% from peak to trough. (ii) They
bottomed a little more than half way through recessions,
recovering significantly before they ended, returning 27%
in 6m and 43% in 12m from the bottom. (iii) They
bottomed well before any of the macro indicators turned.
(iv) Ex post, equity bottoms coincided on average with
GDP growth bottoms, but this data only becomes
available with a lag and is often revised. Waiting for a turn
in the macro indicators before going long equities thus
risks losing out 15-30% returns in equities (Figure 2).
Figure 2: Equities bottom half-way through recessions
100
120
140
160
180
200
220
-300 -250 -200 -150 -100 -50 0 50 100 150 200 250 300
100
120
140
160
180
200
220
RecessionCurrent episode (considering Nov 20, 2008 trough)Average of S&P 500 around recess ions
IndexIndex
Source: NBER, S&P, Haver, Deutsche Bank
In light of further downgrades to DBs US and global
growth outlooks in this World Outlook, we are
lowering our S&P 500 EPS estimates for 2008 to $61
($86 ex-writedowns) and for 2009 to $65 ($73 ex-
writedowns). Our top-down earnings estimates in the
face of the global recession, a higher dollar over the
medium term and lower oil and commodity prices imply
underlying earnings declines of -14.9% in 2008 and
-11.2% in 2009. NIPA profits are measured ex-balance-
sheet adjustments (underlying earnings).
Domestic profits are viewed as the product of margins
and sales, with the former driven by the cycle (operatingleverage) and costs, while the latter are proxied by GDP.
Domestic margins peaked in Q3 2006 and have fallen
significantly. With growth turning down, in spite of the
offset from declining costs, margins are expected to fall
through mid-2009 to about the trough levels of past
recessions (5.3%).
We forecast domestic profit growth to trough in Q1 2009
at -22.1% and then recover but remain negative through
Q3 09. Foreign profit growth looks set to suffer a
significant double whammy from lower foreign growth
and a higher dollar. Foreign profit growth lookss set to fall
from positive mid-teen rates in Q2 2008 to negative -
29.7% in Q1 09. We forecast total profit growth to trough
in Q1 2009 at -24.7% but remain negative through Q3
2009.
Financial sector writedowns have taken a heavy toll on
S&P 500 operating EPS. We estimate that $317 bn in (pre-
tax) writedowns during 2008 will have reduced S&P 500
operating EPS by $25, i.e., 29%. The magnitude of these
writedowns requires some assumption on them going
forward, their tax treatment and accounting practices in
projecting S&P 500 EPS. We assume that capital markets
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losses continue in Q4 at their recent pace but dissipate as
GDP growth bottoms while loan loss provisioning peaks
with a lag. Our assumptions on writedowns implies that
despite declines in underlying earnings, S&P 500 EPS will
grow in 2009 (Figure 3).
Figure 3: Relative roles of domestic and foreign profit
growth to reverse
-30
-20
-10
0
10
20
30
40
Dec-95 Dec-98 Dec-01 Dec-04 Dec-07 Dec-10
-30
-20
-10
0
10
20
30
40
Domestic profit growth yoy
Foreign profit growth yoyTotal Profits growth yoy
%%
Source: BEA, Haver, Deutsche Bank
Figure 4: Trailing multiples during recessions
5
10
15
20
25
30
35
Oct-34 Oct-44 Oct-54 Oct-64 Oct-74 Oct-84 Oct-94 Oct-04
Recession periods S&P 500 trailing PE ratio
0+- 1 s.d. band Average S&P 500 P/E
Low with S&P at 752.4
Source: S&P, NBER, Haver, Deutsche Bank
In the near term and during 2009, we expect that the
prevailing uncertainty about the depth and duration of
the recession will exact a discount on the forward
multiple that equity investors apply to estimatedearnings. Our long-run fair value PE for the S&P 500 is
16.4 (the ex-bubble average of 15.3 adjusted for the lower
interest rate environment). But trailing multiples first fall
(on average -28%) and then recover during recessions as
prices fall in anticipation of the decline in earnings, and
then rise well before the recovery, arguing in favor of
using forward multiples. Long-run average earnings
growth of 6.4% implies a fair value one-year-forward
earnings multiple of 15.4. We apply a significantly lower
multiple of 13.3 to forward earnings at end-2009, before
reverting in 2010 to the long-run multiple of 15.4. The
lower multiple is calibrated to be equivalent to an increase
of 300 bps in HG credit spreads above their average levels
(currently 535 bps above average). It embodies the view
that uncertainty and credit conditions improve in H2 09
(Figures 4-5).
Figure 5: Prices and earnings around recessions
100
105
110
115
120
125
130
-12M -9M -6M -3M 0M 3M 6M 9M 12M
100
105
110
115
120
125
130
RecessionAverage of S&P 500 around Recessions (Trough = 100)Average of S&P 500 EPS around Recessions
IndexIndex
Source: S&P, NBER, Haver, Deutsche Bank
Our top-down earnings estimates and multiples imply
an S&P 500 target of 1140 for 2009 and 1425 for 2010.
In the near term we see the S&P 500 remaining in a wide
range between 800 and 1000. Our US growth forecasts
imply a somewhat extended bottom in growth during Q4
2008- Q1 2009. We thus do not see a sustainable bottom
in equities until sometime in Q1 2009. We remain
overweight US versus world growth, both at the marketand sector level, and thus underweight the global cyclicals
(Energy and Materials). We are also underweight the US
exporters (Capital Goods in the Industrials and Tech). We
are overweight US importers (the Consumer sectors) and
the Diversified Financials (Figure 6).
Figure 6: EPS, multiples and S&P 500 targets
Y e a rS & P 5 0 0 E P S
e s t i m a t eF o r w a r d
P / ES & P
t a r g e t2008E 61.2 - 800-1000
2009E 64.5 13.3 11402010E 85.9 15.4 1425
2011E 93.0
(S&P targets for 2009 and 2010 represent forward P/E
applied to the next year EP S)
Source: Deutsche Bank
Binky Chadha, (1) 212 250-4776
Parag Thatte, (1) 212 250-6605
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Pan-European Equity Strategy: In search of the bottom
European equities APPEAR cheap on nearly all
valuation measures. The current trailing P/E of 8.2x
compares with the 40-year average of 14x and is at the
lowest level since the 70s, when double-digit inflation wasweighing on equity valuations. The P/B of 1.1x compares
with a 29-year average of 1.67x, despite the ROE realized
over the last 12 months still running at a healthy 15%. The
dividend yield of around 5.3% is above the 75-year
average and above the 10-year government bond yield for
the first time since 1954 (Figure 1).
Figure 1: European dividend yield above government
bond yield!
-8
-7
-6
-5
-4
-3
-2
-10
1
2
1933 1947 1961 1975 1989 2003
Div - Bond Yield (avg. of
Germany, UK and France)
%
Source: Global Financial Data Inc, Datastream, Deutsche Bank calculations
The reason is that neither realized profits nor futureprofits expected by the consensus have meaningfully
declined so far. Nearly 40pp of the 50% decline ofEuropean equities since their peak in June 2008 are driven
by contracting multiples rather than earnings. This is true
both on trailing earnings, i.e. the profits realized over the
last 12 months, as well as on forward earnings, i.e. the
profits which the consensus of bottom-up analysts
expects to be realized over the next 12 months (Figure 2).
Three reasons have contributed to the P/E contraction: (1)
Investors demand a higher equity risk premium as
uncertainty has risen. Realised and implied equity market
volatility are at or close to record levels, credit spreads are
at 75-year highs and earnings uncertainty, measured asthe average standard deviation of analysts bottom-up
estimates in the IBES consensus system, has reached a 6-
year high in Europe and a 20-year high in the US (Figure
3). (2) Investors anticipate lower earnings and lower
earnings growth as economic growth falters. (3) Investors
had been concerned about inflation until mid-08 and are
concerned about deflation since then. Both, in a
deflationary as well as in an inflationary environment P/E
multiples tend to decline as real growth tends to be lower
and the required equity risk premium higher.
Figure 2: Equity market decline so far a multiple
contraction story
40
50
60
70
80
90
100
110
1-Jun-07 1-Oct-07 1-Feb-08 1-Jun-08 1-Oct-08
Stoxx 600
Forward P/EStoxx 600 forward ear nings
All indexed at 100 at 1 June 2007
Source: Thomson Financial IBES, Deutsche Bank Equity Strategy
Figure 3: But earnings uncertainty* is at record level
2
4
6
8
10
12
14
16
18
20
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007
US Europe
%
*Average of standard deviation of bottom-up analysts earnings forecasts
for each company as percent of the consensus earnings forecast
Sources: Thomson Financial IBES, Deutsche Bank calculations
In the baseline scenario, we expect European earnings
to decline by 20% both in 2008E and 2009E.Despite
the recent acceleration of consensus earnings
downgrades, consensus earnings growth numbers still
remain far too high at -10% for 2008E and +6% for
2009E. In our view, the problem of estimates is not at thetop line, which should get a sizable boost from the dollar
appreciation. The problem is the margin assumption. We
are projecting EBITDA margins to contract by 1.2pp and
2.5pp in 2008E and 2009E, respectively, substantially
more than currently factored in by analysts. Below the
EBITDA line, we expect the rising cost of interest bearing
debt, goodwill impairment, pension funding gaps and
rising working capital to weigh on profits and/or cash
flows.
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In our view the market has already priced in more
than this forthcoming profit/cash flow deterioration.
We calculate that at the current Stoxx 600 index level of
roughly 200 the market is pricing in a roughly 50% peak to
trough decline in earnings and a 6pp peak to trough drop
in ROE, both more than in the cycles in the last 40 years
and more than we forecast in the baseline scenario. So
while the market looks clearly more expensive on ourbottom-up numbers, it still offers 15-30% upside until
end-09 (Figure 4). Also supported by our other models,
our Stoxx 600 end-09 target is 250 in the baseline case
(see final table for index targets).
Figure 4: and profits will likely come down
substantially2000 2001 2002 2003 2004 2005 2006 2007 2008E 2009E 2010E
Bottom-up
consensus
earnings 14.8 10.6 8.0 11.8 19.3 22.8 25.7 27.5 24.7 26.1 28.6
Growth 3% -29% -24% 47% 64% 18% 13% 5% -10% 6% 10%
Stoxx index at YE 360 299 202 229 251 310 365 365 200 200 200
Trailing P/E at YE 24.3 28.3 25.1 19.5 13.0 13.6 14.2 13.4 8.1 7.7 7.0
Top-down Deutsche Bank earnings 21.7 17.4 20.8
Growth -20% -20% 20%
Required revision of bottom-up consensus earnings -12% -33% -27%
Stoxx index at YE 200 200 200
Trailing P/E at YE 9.2 11.5 9.6
YE level on 38Y average trailing P/E of 14.0 304 243 292
YE level on 38Y average trough P/E of 13.6 295 236 283
YE level on 38Y average trough earnings P/E of 15.2 330 264 317
Source: Thomson Financial IBES, Deutsche Bank estimates
We believe for equity markets it will be crucial whether
global growth stabilises in 2009 or not. However deep the
recession will be in 2009, equity markets should performpositively, if global growth looks like heading towards
some acceleration in 2010. We believe this is even the
case if growth remains sluggish thereafter, as expected in
the baseline scenario. The risk scenario is that global
growth does not trough in 2009, e.g. if neither aggressive
monetary easing nor aggressive fiscal stimulus trigger a
rebound. In this case we see another 20% downside risk
in 2009 (Stoxx 600 target of 160).
Sustainable upswing not likely before end of Q4 08
reporting. For the market to start a lasting rebound we
see the following pre-requisites: (1) Slowing pace of
earnings estimates downgrades (Figure 5); (2)Improvement in lending conditions; (3) Improvement in
consumer confidence; And, (4) improvement of our
proprietary Macro Support Ratio. We do not expect a
lasting rebound before the end of the Q4 reporting. Near
term risks include re-financing needs, higher debt
financing costs, goodwill write downs and pension
funding gaps.
Figure 5: Market moves are related to pace of
earnings revisions
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
0
50
100
150
200
250
300
350
400
450Earnings revision ratio (3 month avg.) (lhs)
Stoxx 600 (rhs)
Latest observation not
averaged
IndexRatio
The earnings revision ratio looks at the number of companies with
consensus
forward earnings upgrades and downgrades over the last month. It is
calculated as (# upgrades - # downgrades) / # of companies in the universe.
Source: Thomson Financial IBES, Deutsche Bank calculations
Growth, large caps and defensives are still the way
forward for now. With regard to investment themes,
we continue to favour large caps over small caps. We also
believe that Growth will continue to outperform Value.
Growth does not look expensive and we find that Growth
has always outperformed Value in years in which global
GDP growth declined by more than 1pp. Cyclicals vs
Defensives is a closer call. Defensives now look more
expensive and are over-owned. Yet, as the backdrop
clearly remains in favour of Defensives we have
maintained a defensive bias with Overweight positions in
Health Care, Telecoms and Oil & Gas. In the last twomonths though we have started to gradually scale back
these O/w positions and, at the same time, added weight
to Basic Materials and Consumer Cyclicals where we are
now slightly O/w and, respectively, less U/w.
Figure 6: End-2009 index targets for European equity
marketsTarget index level for
end 2009
Upside from current
level
Base scenario (60% probability)
Stoxx 600 250 29.5%
Stoxx 50 2650 29.8%
Euro Stoxx 270 27.4%
Euro Stoxx 50 3000 29.4%
FTSE 100 5300 29.4%Dax 5900 31.8%
CAC 40 4000 28.7%
SMI 7000 27.0%
IBEX 35 10700 23.4%
MIB 30 25000 32.4%
Best scenario (15% probability)
Stoxx 600 300 55.4%
Risk scenario (25% probability)
Stoxx 600 160 -17.1%
Source: Deutsche Bank estimates, prices for upside as at 1 Dec 2008 cob
Bernd Meyer, CFA, (44) 20 7547 1533
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Commodities: OPEC action & global growth
We find that OPEC has a good track record ofdefending oil prices via production cuts. However,
their success rate dissolves when global growth is
under attack. We would view events today as reminiscent of
1998 and 2001 when world growth and crude oil
prices collapsed. At those times, the cartel
announced cumulative production cuts of
approximately 5mmb/d, which occurred over a 12
month period.
We believe OPEC will cut quotas throughout mostof next year. However, we believe production cuts
will not immediately rescue the oil price and
consequently we target WTI crude oil prices
hitting USD40/bbl next year.
In fact we find that it is only two to three monthsafter the last quota reduction does the oil pricebegin to stabilise. This would imply a stabilisation
in oil prices around the first quarter of Q1 2010.
History would suggest that crude oil prices canrally between 35-80% when world growth starts
to recover and for this rally to occur within a six
month period. This would imply crude oil prices
back up at USD75-85 by the second half of 2010.
We expect the industrial metals will continue tostruggle in an environment where global equity
markets remain under pressure.
Since 1993, OPEC has taken action twelve times to cut
production to defend the crude oil price. In Figure 1 wetrack the performance of the crude oil price in the two
weeks before a quota reduction and in the subsequent 2-3
month period. We find that since 1993 OPEC has a 75%
success rate of defending the oil price when it takes
action and cuts quotas.
However, on two occasions, 1998 and 2001, successive
rounds of quota reductions were unsuccessful in
supporting the oil price. On a cumulative basis production
cuts amounted to 4.5mmb/d in 1998-99 and 5.0mmb/d in
2001-02. In our view, this reflected the inability of OPEC
to cut production as fast as global oil demand growth was
slowing. In 1998, oil demand was under pressure from
the unfolding Asia crisis while in 2001 oil demand was hit
by a mild US recession. In both years, world GDP growth
slowed to 2.5% or below.
Figure 2 tracks the performance of the crude oil price in
the one, three and six months following a cut in OPEC
production quotas since 1993. We find that on average
quota reductions are effective in pushing oil prices higher.
However, their effectiveness evaporated in 1998 and
2001 with oil prices falling over a one month, three month
and six month horizon despite OPEC action.
Figure 1: Tracking the performance of the crude oil
price following OPEC production cuts
60
70
80
90
100
110
120
130
140
150
-14 -7 0 7 14 21 28 35 42 49 56 63 70
Mar-93 Apr-98 Jul-98
Apr-99 Feb-01 Apr-01
Sep-01 Jan-02 Nov-03
Apr-04 Nov-06 Feb-07
Number of trading days before and after OPEC quota reduction
1998
2001
WTIoilprice=100inthedaybeforequota
reduction
Source: OPEC, DB Global Markets Research
Figure 2: OPEC quota cuts & the WTI crude oil price
Production % change in WTI crude oil pr ice:
cut (mmb/d) 1M later 3M later 6M later
Mar-93 -0.99 -0.8 -2.8 -11.2
Apr-98 -1.76 -1.4 -9.2 3.4
Jul-98 -1.36 -6.7 -12.2 -26.2
Apr-99 -1.41 36.6 37.2 80.2
Feb-01 -1.50 -4.4 -0.7 -8.1
Apr-01 -1.00 8.3 -0.2 -10.9
Sep-01 -1.00 3.2 -19.6 -26.1Jan-02 -1.50 -1.8 32.6 35.4
Nov-03 -0.90 4.5 13.5 28.4
Apr-04 -1.00 4.5 3.6 38.8
Nov-06 -1.70 7.5 -1.0 11.9
Feb-07 -0.50 -3.3 -2.1 1.4
Average -1.22 3.9 3.3 9.8
1998 -4.52 -4.1 -10.7 -11.4
2001 -5.00 -2.4 -6.8 -15.0
Source: OPEC, DB Global Markets Research
These results would imply that the current OPEC quota
reduction cycle will continue until the fourth quarter of
next year. Moreover, that oil prices will stabilise
approximately three months after the last reduction in
quotas has been announced. In other words, crude oil
prices should not hit rock bottom until the very end of
next year/early 2010. We believe at that point a sustained
move higher in crude oil prices will start to become more
compelling. Indeed in the 1998 and 2001 quota reduction
cycles as soon as the last production cut had occurred in
April 1999 and January 2002 within six months crude oil
prices had rallied by 80% and 35% respectively, in line
with the recovery in the world economy at that time.
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How low can oil prices go?
In March 2008, following a doubling in oil prices in the
previous 12 month period, we examined at what point oil
prices could be considered extreme. We presented a
variety of indicators such as oil prices relative to income,
the US dollar and as a share of global GDP and found that
the oil price would need to surpass USD150/barrel for it to
represent levels of valuation which had never beenreached in recorded history. Last month we reversed this
analysis to assess how low oil prices can fall. We selected
a variety of indicators, which are presented in Figure 3. It
reveals that budgetary positions of certain oil producers
starts to become increasingly strained when the oil price
falls below USD55/bbl (Saudi Arabia) or USD95/bbl (Iran
and Venezuela). In terms of marginal cost of production
we set this close to USD80/bbl as the point for trimming
new capital expenditures.
Figure 3: How low can oil prices go?
Indicator Oil price level
Budget balance USD55-95
Marginal cost of production USD80
Based on f utures forecasting error USD80
As a share of S&P500 USD60-90
As a percent of US disposable income USD60-85
As a percent of global GDP USD40-75
Relative to G7 per capita income USD45
Versus US dollar USD30-60
In real terms (PPI) USD35
Average USD61
Source: DB Global Markets Research
While we believe these two indicators are the most
important in setting the long term fair value of crude oil,
the last few months have demonstrated the ability of oil
prices to overshoot to the upside as well as to the
downside. On the indicators we examined, we believe the
extreme low point in crude oil is between USD30-35/bbl.
Indeed we find that oil prices would need to fall to
USD35/bbl in order to bring prices in real terms back to
their long run historical averages.
Industrial metals & the S&P500
The fortunes of the industrial metals complex havehistorically been closely tied to the performance of the
S&P500. We expect the industrial metals will continue to
struggle in an environment where global equity markets
remain under pressure, demand side risks are skewed to
the downside and inventories continue to rise. We would
view aluminium and copper as the most exposed in this
environment. We would view stability to global equity
markets as a necessary condition to avert further
downside in industrial metal prices. Since the S&P500
only tends to stabilise 3-6 months before the end of a US
recession, we believe prospects for the sector will remain
hostile into 2009. Indeed the typical trigger for higher
industrial metal prices has historically been a new
monetary tightening cycle from the Fed, Figure 4.
Figure 4: The performance of industrial metals in the
year after the Fed starts a new tightening cycle
-40
-20
0
20
40
60
80
100
120
140
Nickel Aluminium Zinc
1987 1994 1999 2004
% change in price in the 12 months after the
first tightening move by the US Federal Reserve
58%
42%
30%5% 14%
-4%
Average price rise
in the last four
tightening cycles
Copper Lead Tin
Source: Bloomberg, DB Global Markets Research
Figure 5: DB Oil & Natural Gas Price Forecasts
WTI
(USD/bbl)
Brent
(USD/bbl)
US Gas
(USD/mmBtu)
Q4 2008E 62.00 60.00 6.90
2008E 100.39 98.99 9.00
Q1 2009E 55.00 55.00 8.00Q2 2009E 50.00 50.00 7.50
Q3 2009E 45.00 45.00 7.50
Q4 2009E 40.00 40.00 8.00
2009E 47.50 47.50 7.75
Q1 2010E 50.00 50.00 8.00
Q2 2010E 55.00 55.00 8.00
Q3 2010E 55.00 55.00 8.50
Q4 2010E 60.00 60.00 8.50
2010E 55.00 55.00 8.25
2011E 80.00 80.00 9.00 Source: DB Global Markets Research
Michael Lewis, (44) 20 7545-2166
Adam Sieminski, (1) 202 250 2928
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US: Marking activity down further
Macro-economic activity & inflation forecastsEconomic activity 2008F 2009F 2010F
(% qoq, saar) Q1 Q2 Q3 Q4F Q1F Q2F Q3F Q4F % yoy % yoy % yoy
GDP 0.9 2.8 -0.5 -4.5 -3.7 -2.8 1.0 1.5 1.2 -2.0 1.6
Private consumption 0.9 1.2 -3.7 -2.4 -2.0 -1.7 0.0 1.0 0.4 -1.6 1.0
Investment -5.8 -11.5 0.4 -20.2 -18.7 -14.0 4.2 4.1 -6.5 -11.5 4.3
Govt consumption 1.9 3.9 5.3 2.0 -0.1 -0.1 1.9 2.4 2.9 1.6 2.8
Exports 5.1 12.3 3.4 -10.0 -15.0 -10.0 -5.0 -5.0 7.3 -7.5 -2.3
Imports -0.8 -7.3 -3.2 -10.0 -15.0 -10.0 -5.0 -3.0 -2.9 -9.3 -0.8
Contribution (pp): Stocks -0.1 -1.4 0.7 -0.5 0.0 0.5 1.8 0.7 0.2 0.3 0.5
Net trade 0.8 2.8 1.0 0.3 0.5 0.3 0.1 -0.2 -0.9 0.5 -0.2
Industrial production -0.3 -6.1 0.5
Unemployment rate, % 4.9 5.3 6.0 6.8 7.4 8.1 8.4 8.6 5.8 8.1 8.2
Prices & wag es (% yoy)
CPI 4.2 4.3 5.3 2.1 0.5 -0.5 -1.8 0.4 4.0 -0.4 1.5
Core CPI 2.4 2.3 2.5 2.0 1.7 1.5 1.0 1.1 2.3 1.3 1.2
Producer prices 7.1 7.6 9.4 2.3 -1.8 -4.5 -6.4 -1.8 6.6 -3.7 0.3
Compensation per empl. 3.3 4.0 4.0 3.4 3.2 2.9 2.6 2.4 3.7 2.8 2.7
Productivity 3.3 3.2 2.3 1.2 0.1 -1.1 -1.5 -0.4 2.5 -0.7 1.2
2008 2009
Sources: National authorities, DB Global Markets Research
1. Financial conditions have tightened dramatically
further over the last two months
-4
-2
0
2
4
6
8
10
81 84 87 90 93 96 99 02 05 08
-4
-2
0
2
4
6
8
10
Real GDP Domestic financia l condit ions index*
* Includes M2, bank loans & leases, consumer credit, yield curve,
credit spreads and cyclical stocks.
November
estimate
% yoy% yoy
Sources: BEA, DB Global Markets Research
2. Troubled asset prices made new lows following
abandonment of the original TARP plan
0
500
1000
1500
2000
Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08
0
500
1000
1500
2000
5Y CMBS cash AAA spread to Libor
bpsbps
In our view, the abandonment of the Treasurys original
intention to purchase troubled assets has weighed on
market sentiment and investor risk-taking, potentially
leading to another wave of credit write-downs and loan
losses. This has adversely affected investor confidence,
which should in turn prolong the credit crunch and hencethe economic downturn. This is apparent in financial
conditions, which have become even more restrictive
toward future economic activity. Consequently, we now
expect the economic downturn to be even deeper and more
protracted than we initially assumed. As a result, we are
further lowering our forecasts of growth and inflation.
We expect the Fed to cut rates another 50 bps to 0.5% and
then hold rates at that level indefinitely. We do not projec
the economy to return to trend growth until mid-2010,
which means the unemployment rate will continue to trend
higher as the capacity utilization rate trends lower. As labor
and product market slack open up further, both headline andcore inflation are likely to move down substantially. With
official interest rates steady at 0.5%, the Fed is likely to
pursue more overt measures of quantitative easing, eviden
by the planned upcoming purchases of debt issued by
government-sponsored agencies as well as highly-rated
mortgages. This should help lower borrowing costs and
possibly lead to a mini-refinancing wave, but until the non-
agency mortgage market improves, policy initiatives to date
are likely to have only a muted positive effect on the
broader financial markets. In light of these adverse
economic developments, we now expect substantial fiscal
stimulus in the first half of 2009. Additionally, the sharp
decline in energy prices over the past several monthsshould provide a substantial benefit to cash-strapped
consumers. Sources: Bloomberg, DB Global Markets Research
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US: Marking activity down further
3. Banks are unwilling to provide credit to consumers
-80
-40
0
40
80
66 69 72 75 78 81 84 87 90 93 96 99 02 05 08
-80
-40
0
40
80
Fed's Sr Loan Officer Survey: banks willingness
to lend to consumers
%%
Sources: FRB, DB Global Markets Research
4. The consumer spending share of GDP is bound toslow in the future
60
62
64
66
68
70
72
74
60 64 68 72 76 80 84 88 92 96 00 04 08
60
62
64
66
68
70
72
74Ratio of PCE to GDP %%
Sources: BEA, DB Global Markets Research
5. Low savings and high debt service put US
households in a precarious financial situation
13
14
15
16
17
18
19
80 84 89 93 98 02 07
-4
-2
0
2
4
6
810
12
14
Homeowner financial obligation ratio (lhs)Personal saving rate (rhs)
%%
The credit crunch intensifies. According to the National
Bureau of Economic Research, the cyclical peak in
economic activity occurred in December 2007. At that time
the economy entered a recession, which continues at
present. The economic outlook is likely to continue to
deterioratealthough we believe the sharpest outputdecline will occur in the current quarter. There are few, if
any, parallel periods in the post-WWII era which compare to
the current environment. Arguably, the closest example is
the introduction of credit controls by President Carter in
1980.
In March 1980, President Carter announced the adoption of
credit controls under the Credit Control Act of 1969. These
controls, which were administered through the Fed, were to
be in effect for an indefinite period of time until the
President chose to remove them. The intention of the
controls was to put a brake on excessive money and credit
creation, which was helping inflation move toward 15%.Consumer credit, which had grown 14% in 1979, slowed to
5% growth in Q1 1980 and produced an outright decline of
7% in Q2. With the economy in recession, the controls
were fully lifted by July 1980.
As we have noted on numerous occasions, todays
economic environment bears little resemblance to the 1980
landscapeinflation and interest rates were substantially
higher at that time. Moreover, the 1980 credit crunch was
short and voluntary, lasting just one quarter. The current
credit crisis began in Q3 of last year and has intensified in
force as of late, despite repeated Fed, Treasury and, more
recently, international attempts to thaw frozen credit
markets and restore global financial order.Households are leveraged. Especially troubling to us is thefact the current credit crunch is occurring in an environment
of an extremely cash-strapped consumer. Household
savings are near their all-time record lows, while total debt
service is near its all-time high. The recent hiccup in the
savings rate and modest decline in the debt service burden
are both a function of temporarily higher income resulting
mostly from the tax rebateswhich were primarily saved.
With the labor market poised to weaken further, thereby
putting downward pressure on income creation, consumer
spending is likely to decline substantially. Without easy
access to credit, households will be forced to limit
consumption to the flow of earnings, predominantly fromwages and salaries.
In addition to the credit crunch, households have to contend
with a massive negative adjustment to net wealth. This
should further dampen consumer spending and hence GDP
growth. Indeed, our forecast assumes the economy
experiences the longest and deepest pullback in consumer
spending in the post-WWII period. We project an
unprecedented four quarter decline in consumer spending
in prior instances, consumption has never declined for more
than two consecutive quarters.Sources: BEA, FRB, DB Global Markets Research
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US: Marking activity down further
0
1
2
3
4
5
6
97 98 99 00 01 02 03 04 05 06 07 08
-15
-10
-5
0
5
10
15
20Real GDP (lhs)
Real household net wealth (rhs)
Q4 estimate
% yoy% yoy
6. If sustained, the decline in household net wealth
could offset most of the benefit from lower energy costs
Sources: BEA, BLS, FRB, DB Global Markets Research
7. The credit crunch can be seen across all major
product areas
-25
0
25
50
75
100
90 92 94 96 98 00 02 04 06 08
-25
0
25
50
75
100
Tightening standards for commercial real estateResidential mortgages: net share, banks tighteningBanks tightening standards: consumer credit cardsBanks tightening standards: other consumer loans
FRB Senior Loan Officer Survey
%%
Sources: FRB, DB Global Markets Research
8. An economic trough will not be in sight until the
index of leading economic indicators stabilizes
-10
-5
0
5
10
15
76 79 82 85 88 91 94 97 00 03 06 09
-10
-5
0
5
10
15
Real GDPIndex of leading economic indicators (2Q lead)
% yoy% yoy
How does the current recession compare? In terms ofthe peak to trough decline in consumption, we forecast a
2.5% drop, slightly worse than the two quarter drop which
occurred during the 1980 episode. One of the reasons we
believe consumers will not pull back to an even greater
degree is due to declining energy costs, which should helpUS households. According to our analysis, a $1 decline in
retail gasoline prices creates approximately $100 billion in
added household cash flow. Gasoline prices are down $2
from their peak. Eventually, this should help steady
consumer spending.
Another reason we expect consumer spending to stabilize
is fiscal stimulus. At the moment, we expect the incoming
Obama Administration to enact a fiscal stimulus plan which
will include middle class tax cuts, financial aid to states and
federal infrastructure spending. The total size of the
stimulus package is likely to be around $500 billion. While
the President-elect has not put out a formal stimulus plan,
as he only recently put his economics team in place, we canbe assured from his political mandate that a viable program
will be put forth soon.
In terms of our forecast, we project a peak-to-trough decline
in real GDP of -2.9%. This compares to an average post-
WWII peak-to-trough decline in real output of -2.1%. Our
forecast puts the current projected decline in output on a
par with the 1981-1982 recession. In addition to what we
previously discussed, there are several factors that support
an eventualalbeit anemic in historical contextrecovery
late next year.
First, the projected peak-to-trough decline in GDP does not
fully capture how weak the economy is. With the recessionbeginning in December 2007, our forecast is consistent
with an 18 month recession. This is two months longer than
either the 1974-1975 or 1981-1982 recessions. More
importantly, if we factor in the amount of time in which
economic output has been below trend, illustrated by a
continually rising unemployment rate from its cyclical low,
we would be looking at a four-year period of sub-par
growth.
Second, we expect that all of the various policy initiatives,
such as aggressive Fed easing, the TARP capital injections,
the FDIC ring-fencing of troubled assetswitness the
Citibank bailoutand the most recent announcement that
the Fed will buy mortgage assets and help fund consumerasset-backed securitization, will eventually work. At
minimum, when fully implemented, these various programs
combined with sizeable fiscal stimulus and lower energy
costs should help stabilize the economy.
Three, the economy is generating some pent up demand
that we believe will eventually be unleashed once credit
starts to flow. For example, housing and motor vehicle sales
are at record lows, but these interest-sensitive sectors
should benefit from lower rates once finance companies
become less capital-constrained.
Sources: BEA, Conference Board, DB Global Markets Research
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US: Marking activity down further
External balances & financial forecasts2008F 2009F 2010F Financial forecasts Current 3M 6M 12M
Official 1.00 0.50 0.50 0.50
Fiscal balance, % of GDP -3.2 -8.2 -3.4 3M rate 2.19 1.50 1.50 1.50
Trade balance, USD bn -453 -379 -401 10Y yield 2.58 2.00 2.00 2.50
Trade balance, % of GDP -3.2 -2.7 -2.7 USD per EUR 0.78 1.28 1.28 1.21
Current account, USD bn -677 -519 -465 JPY per USD 92 95 96 92
Current account, % of GDP -4.7 -3.5 -3.0 USD per GBP 1.47 1.41 1.38 1.30 Source: DB Global Markets Research, as of December 5
Joseph A. LaVorgna, (1) 212 250-7329
Carl J. Riccadonna, (1) 212 250-0186
9. Credit market stress must also meaningfully abate
before the economic outlook can improve
0
50
100
150
200
250
300
350
400
Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09
0
50
100
150
200
250
300
350
4003m LIBOR minus 3m USD swap OIS%%
Sources: Bloomberg, DB Global Markets Research
10. Headline inflation will decline in response to rising
labor and product market slack
0.0
2.5
5.0
7.5
10.0
12.5
15.0
69 72 75 78 81 84 87 90 93 96 99 02 05 082.5
5.0
7.5
10.0
12.5
15.0
CPI (lhs)Unemployment ra te/ capacity utilization (rhs)
% yoy %
What are the risks? If the Fed is successful in jumpstarting
the securitization markets, this would help free up
consumer credit growth and therefore consumer spending.
At present, many consumers are shut out of the credit
markets, because of a lack of credit availability. Of course,
there are risks to our projections. Conceivably, the variousFed, Treasury and FDIC programs may not sufficiently
restore investor confidence and fully deal with the problem
of distressed assets remaining on financial firms balance
sheets. However, we believe the biggest risks to our
forecast in the near term stem not from the financial
markets per se, but rather from developments among the
Big Three automobile manufacturers. With the economy
already in recession, we do not believe it can handle a large
bankruptcy; and if one occurred, we would likely be looking
at a double-digit unemployment rate and a much deeper
decline in economic activity than we presently project.
According to industry estimates (Centre for Automotive
Research), 2.5 to 3 million workers could lose their jobs ifthe Big Three filed for bankruptcy. This is not an
unreasonable estimate because, similar to the Lehman
bankruptcy, there would be inevitably negative shocks
associated with any potential automobile industry
bankruptcy, not least of which could be a further collapse in
consumer confidence and thus even greater declines in
consumer spending. In terms of output, we estimate the
Big Three account for upwards of 70% of total US motor
vehicle production. At $350 billion in inflation-adjusted
terms, a 35% decline in motor vehicle output translates into
about $125 billion in lost output, which is worth about 4%
of GDP growth. As such, an automaker bankruptcy could
easily push growth next quarter down by nearly -8%afrightening prospect, to be sure.
Sources: BLS, FRB, DB Global Markets Research
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Japan: Recession to continue through H1 2010
Macro-economic activity & inflation forecasts
Economic activity 2008F 2009F 2010F
(% qoq, saar) Q1 Q2 Q3 Q4F Q1F Q2F Q3F Q4F % yoy % yoy % yoy
GDP 2.5 -3.7 -0.4 -2.3 -2.9 0.0 -2.4 0.3 0.3 -1.7 0.7
Private consumption 2.4 -2.2 1.1 -0.6 -0.2 3.6 -3.6 0.8 0.7 0.1 0.6
Investment 2.0 -6.5 -3.5 -3.6 -4.5 -4.5 -3.3 -2.2 -2.9 -4.0 -0.6
Govt consumption -1.8 -0.4 0.3 1.6 1.6 1.6 1.6 1.6 0.3 1.3 1.6
Exports 14.5 -10.2 2.8 -12.5 -8.0 -4.5 -3.6 -2.7 4.7 -6.2 0.2
Imports 5.0 -11.5 7.9 -9.5 -4.5 0.3 -1.2 -0.4 0.0 -2.9 1.9
Contribution (pp):
Private inventory -0.8 -0.2 0.2 -0.5 -1.4 -0.7 0.4 0.4 -0.2 -0.5 0.3
Net trade 1.7 -0.4 -0.4 -1.1 -0.8 -0.7 -0.4 -0.4 0.7 -0.7 -0.2
Industrial production -2.9 -3.3 -5.1 -11.5 -7.8 -5.9 -4.7 -3.9 -1.1 -6.9 -1.5
Unemployment rate, % 3.9 4.0 4.1 4.1 4.3 4.5 4.8 4.9 4.0 4.6 5.2
Prices & w ages (% yoy)
CPI 0.9 1.3 2.2 1.6 1.1 0.4 -0.8 -0.8 1.5 0.0 -0.5
Core CPI 1.0 1.5 2.3 1.7 1.0 0.4 -0.8 -0.8 1.6 -0.1 -0.5
Producer prices 3.5 4.9 7.1 1.2 -3.3 -7.0 -10.2 -5.8 4.2 -6.6 -1.3
Compensation per empl. 1.3 0.7 0.3 -0.6 -1.8 -2.0 -2.2 -1.5 0.4 -1.9 -0.5
Productivity 0.5 1.8 1.3 1.8 1.0 1.1 0.0 0.3 1.3 0.6 1.5
2008 2009
Sources: National authorities, DB Global Markets Research
1. Leading index has already fallen substantially
80
85
90
95
100
105
110
90 92 94 96 98 00 02 04 06 08
85
90
95
100
105
110Leading index: DBCLI-ECONOMY (rhs )
Cabinet Of fice coincident index (lhs)
CY2005=100 Jan 1995=100
Sources: Cabinet Office, DB Global Markets Research
2. Export volumes on the decline to all destinations
40
50
60
70
80
90
100
110
120
130
93 95 97 99 01 03 05 07 09
US
Europe
Asia
All regions
CY2005=100, sa, 3mma
Japans recession is likely to continue through H1 2010,given the severity of the ongoing global recession, JPY
appreciation, and the substantial fall in the leading index
of the business cycle. We expect the depth and
duration of this recession to be almost as severe as the
one which started in February 1991. We expect real GDP to shrink for six consecutive
quarters through Q3 2009, led mainly by weakness in
exports and private capital investment where we
expect both of them to shrink QoQ throughout 2009. A
2% slower global GDP growth and 10% JPY
appreciation would lower real exports by 10% points, a
substantial drag to economic activity.
Private consumption is likely restrained by ongoinglabor market softening. Recovery in real purchasing
power from falling oil prices and JPY appreciation
should not be considered supporting factors for
consumption. Remember that in the past business
cycles, deterioration (improvement) in the terms oftrade accompanied economic expansion (recession).
Prices, as lagging indicators of the business cycle, havealready peaked in Q3 2008 and are likely to fall in Q4
2008 onward. A modest degree of deflation should
prevail again in Japan through 2009-10.
Sources: Ministry of Finance, DB Global Markets Research
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Japan:Recession to continue through H1 2010
Mikihiro Matsuoka, (81) 3 5156-6768
We doubt the validity of the arguments that Japan isimmune because it is not at the epi-center of this
financial crisis; its financial system is undamaged;
inventory levels are under control; and capital
investment is entirely financed by cash flow.
This argument, does not take into account dynamicalaspects of the business cycle: 1) Japans economic
activity has clearly been affected by international trade
and currency. 2) Prolonged and severe recession would
eventually result in newly generated bad loans, which
could trigger another credit crunch. 3) A sense of
excess in inventories is determined not only by supply
but also by demand; a substantial weakness in demand
would push up inventories, which in turn leads to cuts
in production. 4) A severe and prolonged recession
eventually curtails profit so that companies would have
to borrow from banks.
Most of the fiscal stimulus packages require theapproval of the second supplementary budget by theDiet, but this may not be obtained easily in the Jan-09
session. This package includes JPY2trn coupon
payment to all households. We expect the BoJ to cut
rate by 20bp in Q1 2009, but do not expect a return to
either zero interest rate policy or quantitative monetary
easing, because of their doubt over the effectiveness of
such extreme policies.
The next economic recovery is unlikely to be V-shaped,led by exports. Stabilizing domestic demand, instead,
would slowly lead to recovery, albeit at a pace of
potential growth at best in our view.
External balances & financial forecasts2007 2008F 2009F 2010F
M2 + CD growth, % 1.6 2.2 2.2 2.1
Fiscal balance, % of GDP -0.8 -2.8 -4.2 -5.1
Public debt, % of GDP 162.8 167.6 174.0 0.0
Trade balance, USD bn 105.8 44.4 74.5 90.8
Trade balance, % of GDP 2.4 0.9 1.4 1.6
Current account, USD bn 211.3 174.0 239.2 303.2
Current account, % of GDP 4.8 3.5 4.5 5.4
Financial forecasts Current 3M 6M 12M
Official 0.30 0.10 0.10 0.10
3M rate 0.89 0.85 0.85 0.85
10Y yield 1.38 1.50 1.50 1.30
JPY per USD 92 95 96 92
JPY per EUR 118 122 122 112
5. Credit spreads have widened even in Japan
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
3/04 9/04 4/05 11/05 6/06 1/07 8/07 3/08 10/08
BBB corporate
AAA corporate
JBG 5-year
%
3. Prices likely to fall
:
94
96
98
100
102
104
106
108
110
112
114
116
00 01 02 03 04 05 06 07 08 09 10 11 12
Domestic CGPI
National CPI excl. fresh food
National CPI excl. energy and food
CY2005=100
Forecast
Sources: Ministry of Internal Affairs and Communication,, DB Global Markets
Research
4. Inverted terms of trade as coincident indicator
60
70
80
90
100
110
120
80 84 88 92 96 00 04 08
40
60
80
100
120
140
160
180
200
Terms of trade; finished goods prices/raw
material prices (rhs)Industrial production (lhs)
CY2005=100 CY2005=100
Sources: Bank of Japan, Ministry of Economy, Trade and Industry,
DB Global Markets Research
Sources: National authorities, DB Global Markets Research, as of Dec 5 Sources: Bloomberg, DB Global Markets Research
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Euroland: A deep recession
Macro-economic activity & inflation forecasts
Economic activity 2008F 2009F 2010F
(% qoq, saar) Q1 Q2 Q3 Q4F Q1F Q2F Q3F Q4F % yoy % yoy % yoy
GDP 2.7 -0.8 -0.9 -3.2 -4.7 -3.3 0.2 0.7 0.9 -2.5 1.0
Private consumption -0.1 -0.6 0.0 -1.2 -1.2 -0.8 0.0 0.4 0.3 -0.7 0.5
Investment 6.1 -4.6 -2.4 -7.8 -11.5 -11.5 -2.0 0.0 1.1 -7.4 0.0
Govt consumption 1.2 2.2 2.8 2.0 2.8 2.8 2.8 2.8 1.7 2.6 2.6
Exports 7.3 -1.5 2.4 -2.0 -0.8 -2.8 -0.8 -0.8 3.2 -1.0 0.5
Imports 7.9 -1.6 7.0 -1.6 0.0 -0.8 0.0 0.8 3.4 0.3 0.7
Contribution (pp): Stocks 1.2 0.2 1.0 -1.0 -1.7 0.0 0.4 0.6 0.2 -0.4 0.3Net trade -0.1 0.0 -1.9 -0.2 -0.4 -0.9 -0.4 -0.7 0.0 -0.6 -0.1
Industria l production 1.4 -1.9 -2.8 -6.6 -9.0 -6.6 -0.8 -0.2 0.0 -5.4 1.0
Unemployment rate, % 7.2 7.4 7.5 7.7 8.0 8.5 8.9 9.2 7.4 8.6 9.7
Prices & w ages (% yoy)
HICP 3.4 3.6 3.8 2.4 1.7 1.1 0.7 1.4 3.3 1.2 1.4
Core inflation 1.8 1.7 1.8 1.9 1.9 1.9 1.7 1.6 1.8 1.8 1.1
Producer prices 5.4 7.1 8.5 4.8 2.2 -0.1 -1.8 0.3 6.5 0.2 0.2
Compensation per empl. 3.3 3.8 4.2 3.6 3.2 2.4 1.9 1.5 3.7 2.3 1.5
Productivity 0.5 0.2 -0.2 -1.0 -2.3 -2.1 -1.3 0.0 -0.1 -1.4 1.4
2008 2009
Sources: Eurostat, DB Global Markets Research
1. GDP to decline 2.5% in 2009, worst since WWII
-4
-3
-2
-1
0
1
2
3
4
5
00 01 02 03 04 05 06 07 08F 09F 10F
Consumption GovernmentInvestment StocksNet trade GDP
Contributions to annual GDP growth
Forecast
Sources: Eurostat, DB Global Markets Research
2. Peak-to-trough output destruction of 3.3%
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
1971 1975 1979 1983 1987 1991 1995 1999 2003 2007
Euro area GDP growth, % qoq
Forecast
Growth: The outlook has deteriorated further since our WO
Update in mid-October. We now expect the euro area to
contract by 2.5% in 2009, with a peak-to-trough decline in
output of 3%, the largest on record (since 1960).
Technical recession in Q2-Q308 has been confirmed. The
main drags were the spike in commodity prices and thedeclining housing/construction cycle. As Q3 unfolded,
discretionary spending (cars, trucks, machinery, etc) started
to roll-over, suggesting the euro area was on the verge of
slipping into self-reinforcing recessionary dynamics. The
escalation of the credit crisis in late September was a blow,
creating an inflection point into Q4. Surveys imply that
output in the final quarter will fall at the fastest rate since
1974. Despite a rapid decline in supply, stocks, which
increased sharply in Q3, have risen further. Anecdotal
evidence points to lengthy production holidays from late Q4
well into Q1. We have cut our Q4 GDP forecast from -0.5%
to -0.8% qoq and our Q1 forecast from -0.6% to -1.2%. The
credit crunch is restricting the supply for credit. Risinguncertainty is reducing the appetite for investment
(business investment is starting to contract, adding to
declining housing and construction) and consumption.
Falling demand is pushing unemployment higher quickly,
reinforcing household sector retrenchment; declining house
prices will weigh on consumption too. At the same time,
foreign demand is contracting. For the next couple of
quarters, we believe this spiral will be largely unbreakable.
However, around the middle of 2009, activity will have fallen
below minimum levels and some catch-up activity should
then occur. This process is normally supported by an easier
policy environment. Looking into 2009, policy decisions
outside the euro area maybe as important as those athome. We expect GDP to grow 1% in 2010.
Sources: OECD, Eurostat, DB Global Markets Research
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Page 22 Deutsche Bank Securities Inc.
Euroland: A deep recession
Mark Wall, (44) 20 7545-2087
Inflation